Thomas Barrack Jr.

Thomas Barrack Jr.

THOMAS J. BARRACK JR. is the Founder, Chairman, and Chief Executive Officer of Colony Capital, LLC, and Colony Advisors, LLC. As such, he provides overall strategic and investment direction and leadership to the firm.

http://www.twst.com/interview/14942

TWST: Would you begin with an overview of Colony Capital?

Mr. Barrack: Colony Capital is a 12 year old private equity real estate fund whose primary purpose is to invest in real estate and real estate operating companies, with the goal of producing above-average returns over a five- to seven-year holding period. Our shareholders are public and corporate pension funds, college endowments and high-net-worth individuals looking for above- average returns in the hard-asset sector. Colony seeks opportunities in inefficient markets in order to achieve its return expectations. Thirty years of experience in the real estate business have made us conclude that efficient frontiers will force returns to regress to the mean.

TWST: How popular have you been over the past two years?

Mr. Barrack: We have been very popular over the last two years, although we weren't so popular in 1997 and 1998 when people were measuring our returns (which were in the 20s) against the astronomical expectations of the VC and technology telecom sectors, which at that point in time were in the stratosphere. Colony's business started in 1990 at the onset of the RTC debacle. Our investment philosophy was an outgrowth of the successful investment philosophy utilized while at the Robert M. Bass Group in the mid 1980's. We had acquired American Savings Bank which was the first 'good bank-bad bank' structure from the Federal Government. In liquidating the bad bank's $15 billion of troubled assets we gained great expertise in the non-performing loan business. Consequently, in 1990 we formed Colony to focus specifically on that huge inefficient and distressed market place. We became one of the largest acquirors of non-performing loans in the US. As we moved through 1994 and 1995, Colony's business continued to be what we call the 'rescue and restructure' business. In 1995, the US marketplace started to show characteristics of becoming efficient once again in the real estate sector. The rescue and restructure era had, for the most part, healed itself. We then went to Europe and the UK, armed with the tools that had worked so successfully in the US and bought non-performing loans there. The European market was cycling about four to five years behind the US market and was still in chaos. In America, where the market had started to become efficient, we were buying value-added assets. The European marketplace then started to show signs of recovery in 1997 so we moved our rescue and restructure business to Asia and continued with complex and contrarian investments in Europe. The Asian contagion was just starting as a result of the currency demise in Malaysia. We've been investing in distressed assets and debt ever since in Japan, Korea and Taiwan.. Our business has been pretty stable and continuous, although during the four or five years of the Tech, Media and Telecom (TMT) craze the USA investment community was experiencing a capital blitz based on unrealistic expectations and hard assets were thought to be an old and boring smoke stack industry. In the midst of the momentary investor euphoria we in opportunity fund land thought we were in Jurassic Park because we were producing IRRs in the 20s which appeared to be lower than the meteoric heights of TMT stocks. In retrospect, we look pretty heroic! We're very happy that we stuck to our knitting for the most part.

TWST: You mentioned in your introduction that you're an equity investor at this point. Are you no longer working on the financing side or on non-performing notes?

Mr. Barrack: We do, but we buy pools of non-performing loans. We buy portfolios of complex assets and non-performing loans, we acquire operating companies which are dependent on underlying real estate assets, we buy and reposition complex real estate assets, such as hotels and office buildings. All of these executions require a global knowledge of financing and capital markets. The financial engineering contribution to yield in such transactions is critical. We have one of the best CFOs and financial departments in the industry. These businesses seem to continue through their cyclical life in different geographical locations. The rescue and restructure business for non-performing loans started in the US, jumped to Europe, then to Asia and is starting to return a decade later to the US once again. Our business is really made up of three parts. One is rescue and restructure, troubled non-performing loans and assets, basically ' distressed debt. Secondly, we invest in operating companies which are real estate dependent. The complexity of an operating company which is highly dependent on its underlying real estate assets presents great arbitrage opportunities between markets. Private equity corporate investors traditionally do not target real estate rich companies due to the 'lumpiness' and 'non- leveragability' of real estate. Real estate investors, alternatively, are normally not armed with the tools of corporate finance, accounting and knowledge of Wall Street to maximize potential of the structure or the assets. At times the corporate market places a discount or premium on its shares and at times the real estate market places a discount or premium on its assets. Thirdly, we buy single assets or portfolios which need 'value added' repositioning. We take assets that have an intended purpose and change the purpose, alter the capital structure of use. Many times assets suffer from physical, financial or functional obsolescence. We rehabilitate them. Our arsenal of tools include expertise from real estate, distressed debt, bankruptcy, Private Equity corporate, global finance, Wall Street, Main Street and emerging markets.

TWST: Out of those three areas, how active has each been over the past six to 12 months? What do you anticipate as that activity level over the next 12 months?

Mr. Barrack: That's a good question. Let me address it geographically for you. In the United States the phenomenon has been primarily one of deteriorating fundamentals. In other words, the real estate business, at the fundamental stage, the operating stage, has gotten worse and worse for the past two years. Values have been elevated due to preservation of capital with too much money that has exited the equity market and is looking for a place to park fueled by historically low interest rates. So in the US, while you would depict the real estate market as getting worse (rents are decreasing and vacancy rates are increasing in the office and multifamily apartment sectors, sales per square foot in retail malls are decreasing) prices that people are willing to pay for a deteriorating product are getting higher because a new source of money has entered the real estate segment after the retreat of 401(k) plans and the general market. In essence these investors are willing to pay more for less on an absolute return basis. However, real estate returns still look strong compared to alternative investment classes, on a relative performance basis. Even though in the US the fundamentals have deteriorated, there has been relatively little distress in real estate so far because lenders have been pummeled with the TMT sector problems. This, for once, has been a moment in which the lenders have not found real estate to be the drunk driver along the highway of the economy. As a result, they have limited their real estate lending, primarily, to the single-family arena. Additionally, demand has completely retracted. Usually, in a real estate recession, real estate developers will lull themselves into a recession. So if a real estate developer can borrow money and build, they will, and eventually there's an oversupply. In this retraction, though, there hasn't been an oversupply; there is just an incredible retraction of demand. So the US has been a fairly efficient environment. And in this efficient environment, for investors like us, there are not great opportunities because everybody has pretty much the same information: we see the fundamentals deteriorating; we see that leverage has been adjusted with historically low interest rates, unlike 1989-1990-1991 when interest rates were crippling the owners and forcing dispositions. Looking at the artificially high prices and the deteriorating fundamentals, we have been net sellers in the United States for the last 15 months. We have taken advantage of the moment ' and the moment has been a harvesting moment, not a planting moment. Europe is cycling closely behind the US, and it too is now starting to suffer from deteriorating fundamentals. But supply is always dramatically lower in Europe, and Europe also is benefiting from an oversupply of capital, which is a result primarily of the big German funds. Germany has created a tax-advantage investment program for individual investors, providing a significant tax benefit for them to invest in real estate pools, and those real estate pools are required to invest in investment-grade properties ' primarily in Europe, although now they've expanded into the US. As in America where you've seen deteriorating fundamentals but increased capital and, consequently, lower cap rates and increased value, the same thing has happened in Europe in that the German funds have been voracious acquirers of institutional-quality property. And of course, the development pipeline in Europe is limited. It's very difficult to develop in Europe because there is less land, there are higher regulatory barriers, etc., and the rescue-and- restructure phase in Europe has wound down because the banks have disposed of a majority of the NPLs. Corporate outsourcing and public-to-private dispositions create the headlines for new 'buy' opportunities in Europe. Italy, Spain and France appear the most attractive at the moment. In Asia, quite the opposite is true. Asia has found itself in a state of permanent restructuring. Korea has done the best job in solving its NPL and banking problem, although we still have an active NPL program there. Japan is still suffering enormously. We're very active in buying loans and assets in Japan. Nothing has happened as fast or ferociously as any of us has wished, but it has been continuous. Taiwan is now addressing its banking problem and is now the flavor of the month for distress players who are looking for non- performing loans. Similarly, China is addressing its own banking problems and is the future for all of us trying to get a level playing field in the rescue-and-restructure business. The value- added business across Asia has not been addressed because we're not at that point in the cycle yet. Looking at the state of the globe from our limited vantage point, it's primarily a time to sell in the United States. There will be harvesting opportunities to realize investments that were made three, four and five years ago. There will also be occasional buy opportunities that will become broader and more vigorous when the equity markets recover, at which point capital will retreat from real estate and go back into equities; or, interest rates will rise, which will force the holders of marginal properties to dispose of them. Whether that's six, 12 or 18 months from now, we don't know. Europe is still a clubby atmosphere. There are still great acquisition opportunities in Italy, some opportunities in France and good ones in Spain. The currency, of course, has been a boon to all of those who have been big investors in the Euro through properties. And in Asia, it will continue to be rescue-and-restructure and distress.

TWST: Do you see the flows of capital that you've seen over the past two years continuing over the next 12 months?

Mr. Barrack: Yes. I think for pension funds, it's a very difficult time because their returns over the last 24 months have not met their expectations. Consequently, the corporate pension funds are now challenged to make contributions to their retirement funds, whereas before they were booking profits. Everybody has hired consultants to help them decide whether they need to re-engineer their hurdle rates or their target yield rates. The allocations that they have in their portfolios between equities, bonds, real estate and alternative investments are all being second-guessed, and the current cash component of their yield as they match their assets and liabilities is becoming challenged. So you have a bit of paralysis while the institutional pension fund world checks itself and tries to adjust for what it perceives to be the next few years of this economy, which is, of course, difficult. Add to this war, terrorism and questionable recovery, and it spells 'paralysis.' Meanwhile, those investors who were in the alternative investment cycle have found a set of confusing problems: one, realizations have been lower than expected because there has been no public exit for the LBO players; two, many of the large funds have not been able to invest the money, so they're paying fees on uninvested capital; three, ironically they are finally looking at pricing as being beneficial to those LBO buyers who are beginning to look at properties at pricing levels that make sense. Consequently, there's a bit of confusion about allocations in the alternative investment business. Likewise, in the real estate business, those who have invested in US funds are finding that it has been difficult to put the money out in US properties, so their allocations as a percentage have increased. Even though a fund that may have had a 3% allocation in real estate was at 2% since the value of their equity portfolio dissipated as a percentage, that real estate investment now may be 6%. As a result, they might look at real estate and say real estate is the place we should be. But since their allocation is double what their universal application was, they have to go back to a consultant and change that. You find it to be one of those moments where there's a bit of paralysis across the system as to asset classes. This translates into opportunity for those who have the fortitude and knowledge to act while others are frozen. There is quite a bit of capital, although not much capital is being targeted at the international markets and the US market is a little slow to get there. Also, very few sponsors are internationally equipped.

TWST: Do you see the universe of clients that you have historically or traditionally addressed changing or expanding at this point?

Mr. Barrack: Yes. And I think they all have to, for different reasons. Again, within the institutional environment, real estate current income as a component of total return is becoming more attractive: five years ago, current income as a percentage of total return was irrelevant; today it's becoming very relevant. A year and a half ago you saw a huge interest in REITs because a 7% or 8% FFO payout to an institution when looking at a total of a 10% return was very, very attractive. They could match assets and they could match liabilities. I think sensibility is coming back into the marketplace. The confusion of trying to understand what is true residual value in these other asset classes makes real estate simple because you're dealing with hard assets with relatively less volatility. Interestingly, the first opportunities will be the more volatile opportunities. For instance, the hardest hit sector of the US marketplace has been the hospitality business, and that will probably be the first place to find buying opportunities in the near future.

TWST: Would you walk us through your top management team, highlighting the skill sets and the bench strength you have at Colony Capital?

Mr. Barrack: That's a key question. Globalization is more than a term. It's really the world that we're living in today, a world in which money is homogeneous and will instantaneously move to the highest return. Recognizing that we're living in those capital markets, Colony's management across the world is comprised of nine principals, all of whom are lawyers, MBAs, architects or financial experts, and in most regions the managing partner of that region is a local; in France it's a Frenchman, in Tokyo it's Japanese, in Korea it's a Korean. What we've done is centralize three things: the investment decisions, the financial functions and the legal functions. Essentially, all conceptual and legally significant decisions regarding commitment of capital are made by the central organization, while all of the operating pieces are actually controlled in the region by our local management team as we try to adapt to the specific cultural orientation. Consequently, our entry in many instances has been through a local vehicle. In Korea, for instance, we entered into a joint venture with KAMCO, which is a Korean government entity; in Hong Kong we entered into a joint venture with Kerry Properties, the Kwan Family; in Japan we entered the market by buying an interest in Aozora Bank; in France our partners are Lazard, Accor, Eurazeo, French institutions and entities. And the financing function or the currency function itself, the balancing or hedging operation, is actually quite significant in these operations when you're running $4 or $5 billion among seven or eight countries at a time. So it's a centralized finance, legal and investment program with the deal teams and the asset teams in the field usually staffed by nationals of that country.

TWST: You mentioned public-to-private culling. Do you see that as a good value proposition at this point? Do you see an increase, for whatever reason ' because of the interest rates or because of companies looking at their own portfolios ' in that culling process at this point?

Mr. Barrack: The answer is in two parts. There are two types of public-to-private transactions. Remember that the next cycle will be private-to-public. Traditionally, looking at a public company and saying that the NAV exceeds the share price is always difficult because, for instance, in the UK, where that may be happening today, the premium that you would have to pay in order to control the company is terribly significant. So I don't see too much of that. Secondly, what we do see a lot of are corporations desiring to get rid of their real estate. That's happening en masse. Every corporation basically looks at real estate as being a heavy weight on its balance sheet, so the outsourcing of corporate ownership of office buildings, industrial buildings and multifamily centers has been quite extensive, especially in Europe. I think in Europe you're going to see much more of that as cross-border multinational companies dispose of their real estate in preparation for the next phase of merger-and-acquisition activity. I think most of what you're going to see on the corporate side are corporate dispositions of properties through financiers who will then carry the assets on their balance sheet.

TWST: Does that tilt the supply and demand balance when you look at value?

Mr. Barrack: Yes. And again, the demand side continues to retreat, but the value of those types of engineering transactions is really the financial engineering. A corporation that's interested in selling its corporate operations remains as a tenant, so in that sense it's sale and leaseback with a terminable period of time, which affords you income in place and then a repositioning at the expiration of that lease period. What corporations are trying to do is to get an entrepreneur to carry that balance sheet risk and that occupancy risk after a certain date. It is, therefore, a safer opportunity because you're evaluating the credit of the corporate disposer. But the upside is much more limited. That's one of the flavors of the month in Europe at the moment. The question is, do rents go up or down in four years?

TWST: You mentioned Asia as one of those market regions that you are active in. What role have the changes in banking coverage for deposits, when we look at the default and mortgage problems throughout Japan and in Korea, played in those particular markets as far as current demand and current supply?

Mr. Barrack: Today, I would say there is more money waiting for transactions than there are transactions. The Japanese market continues to spiral downward, but because of the high savings rate and the low consumer rate in Japan, the disposition side has been phenomenal. For buyers such as ourselves who can buy portfolios from Japanese banks and then enter into dispositions with individuals ' what we call 'discounted payoffs' or 'friendly foreclosures' ' the velocity is very high because there's plenty of cash in the system. The difficulty is getting the banks to sell the loans. That's as opposed to Korea, which addressed the problem aggressively and solved it very quickly. In Korea, the supply of product is becoming very efficient and is starting to wane. In Japan, however, there's what most of us think is more than a trillion dollars in non-performing loans, but the banks refuse to cure their problems by selling them at a decent velocity. Now Taiwan has decided that it is going to take an RTC approach to solving its problem, so it's winding up again and there's about the right amount of capital. These places are very difficult. When you think of how difficult it is to do business like this in the US, and you compound it with a currency, cultural and language challenge, a legal system that's confusing and a political situation that's unknown, the risk premium by newcomers to these markets has to be significant. Consequently, there is not an overabundance of capital chasing those kinds of transactions. It is hard work in that the cultural orientation to distressed banking in these sectors is much different. Therefore it goes more slowly and we're a little more cautious, but it has been very lucrative for those players who have had the patience to stay in the markets.

TWST: What would you see as the particular agenda for Colony Capital over the next 12 months? What would make that time frame a success from your own operational viewpoint as well as from a market's viewpoint?

Mr. Barrack: Our plan is very simple: we are the only privately held opportunity fund that has an international platform. If you look at our competitors, with whom we're actually quite close and sometimes invest together, many of whom are large investment banks (Whitehall and Goldman, Morgan Stanley Realty and Morgan, Lazard, Blackstone), they are all conglomerate private equity groups that have real estate as one of their businesses. We are one of the only private equity groups that has real estate as its only business and that has an international platform. The key to this business is adaptability. You have to be able to change your mind in 10 minutes ' which is almost anti-institutional because, when you think of it, most institutions say, 'Give me an investment premise and stick with this investment premise for seven years.' The problem is, it's difficult today to stick to the investment premise for seven days before the world turns! Our real advantage is that we can move capital among the seven countries that we deal in quite actively now and are able to find the best and highest use with the lowest risk profile for that money. Where is that today? Europe on a defined basis. We have an existing collecting entity in Europe. Europe has less up and down volatility than the US. In places like Italy there are many public-to-private transactions taking place in which billions of dollars of real estate and real estate securities are being syndicated. The same is true in Spain and in France, where there are still isolated individual opportunities, especially in the corporate divestiture arena. In Asia, the distressed, the rescue- and-restructure is significant. We're moving into China. We have just opened a Shanghai office and are looking at China as a big market for us in the future. In the US, it's mind our powder, wait for further reconnaissance, let this market jiggle a little bit, and hopefully we will see another cyclical round of buying opportunities some time in the next 18 months. In the meantime, we continue to sell into the market in the US.

TWST: We only mentioned the value of the dollar as an operational issue. Is currency having more than a marginal impact on where investors are looking or how some of this globalized real estate market is reacting?

Mr. Barrack: Not really, because I think smart investors and real estate operators look through the currency situation. In other words, they're as close to being perfectly hedged as they can be so that they're revenue neutral, rather than trying to target a real estate market based on the currency adjustment. We do get windfalls as a result of this, but we don't really look at it as an adjunct part of our business. Actually, we try to engineer that risk out of the transactions. But I think what you're going to find is that if this goes on much longer, Europe is going to deteriorate a little more quickly on the demand side because they're going to become noncompetitive on the manufacturing side. Despite having a currency win of the Euro versus the dollar, it will penalize the users of our space across Europe over time, and that needs to be factored in. So I think we're pretty much currency neutral.

TWST: When you take that scenario where perhaps a large-scale quantity of manufacturing real estate may not necessarily become vacant but may get less and less utilization, how, on a two- to three-year basis, can you take advantage of that kind of knowledge?

Mr. Barrack: I think you have to pick your spots. An example would be the large corporations that are looking to exit and that will sell their buildings and take back a two to three-year lease while you reposition the property for some other purpose or use. Those are the opportunities. I think in Europe the opportunities are more micro. They're one-off. You can't take a macro view any longer. But I think worldwide at the moment you have some deflationary characteristics, which traditionally are not bullish for real estate. This is the amazing thing that's happening in the US: real estate is becoming more dear; but if you evaluate it from a deflationary point of view, almost every indicator you look at screams of deflation, while you have aggressive pricing and funding coming at real estate very hard, which tells you that the market doesn't believe it. Now, how many times you can keep that battering ram running against the same income stream and have a defined gravity is the real question. The only truism is change. Change usually happens in repetitive cyclical movements. The world usually predicts the reoccurrence of those cycles en mass. The good investors go the contrary route. Contrarianism, discipline and adaptability are the pistons of our business engine.

TWST: Thank you. (DWA)

THOMAS J. BARRACK JR. Chairman & CEO Colony Capital, LLC 1999 Avenue of the Stars, Ste. 1200 Los Angeles, CA 90067 (310) 282-8820 (310) 282-8808 - FAX www.colonyinc.com

http://www.twst.com/interview/14942